Would You Take An Interest Only Mortgage?

Updated 18 May 2016 – By Loanstreet


In various countries, an Interest Only Mortgage is seen as a great option when purchasing a home. Although currently not available in Malaysia, would you take one if it was?

If you are familiar with amortization, you should be knowing that your Normal Mortgage payment will go towards interest and principal account (the loan balance) if you take a Normal Mortgage. Eventually, you will pay off your interest account and your loan balance will be paid off gradually too. However if you choose an Interest Only Mortgage, you will be paying just the interest. This means that your loan balance remains the same but you are obliged to pay back the total unchanged loan balance at the end of the mortgage.
 

The following chart shows the difference between Normal Mortgage and Interest Only Mortgage.

Will You Take An Interest Only Mortgage

For the loan balance left in the Interest Only Mortgage, there are typically 3 ways to repay it:

  1. Sell the property and use the proceeds to pay back all at once

  2. Invest the extra cash into investment or savings plan in hopes to accumulate enough sum to pay off the loan balance in the end

  3. Take on another Normal Mortgage to payoff the loan balance.

Pros of Interest Only Mortgage

  • Low monthly payment for high value property

If we take on a 450k mortgage loan with an interest of 4.5% per annum for a duration of 20 years, our monthly repayment for the Normal Mortgage and Interest Only Mortgage will be the following:

Will You Take An Interest Only Mortgage

Will You Take An Interest Only Mortgage

If you look at the difference in payment, you are saving RM1,159.42 every month. You can utilize this extra money for your personal spending or used it for investment to generate extra income.

  • Flexible Payment

Interest Only Mortgage allow you to make flexible payment to your loan balance at your leisure to decrease the loan balance. In fact, financial institutions encourage their borrower to make irregular payment towards the loan balance because they are worried that they may not be able to repay the full amount in the end.

By making irregular payment, you are also decreasing the interest incurred monthly. Unless you have the confidence that you can invest and get a larger return than 4.5% per annum, then you should invest first and use the return to make such flexible payment later.

This flexibility is very attractive for non-fixed salary/commission earners because they can make irregular payments according to their income.

  • Increase value = profit

Due to the low payment of Interest Only Mortgage, you can afford to buy a more expensive property which will increase its value in the future. At the end of the mortgage period, if the value of the property is indeed higher than the loan balance, you can always turnover the property and earn the difference. Effectively, you are renting the property for low cost and gaining profit at the end of your rental!

Cons of Interest Only Mortgage

  • No increase in equity

As we have mentioned earlier, due to paying for just the interest, the loan balance remains the same unless you made extra payment towards your loan balance. If the loan balance remain unchanged,  even though you bought the property for so many years, you didn’t make any progress owning it so the bank will still expect the full loan balance to be paid off before releasing the ownership to you.

  • >Decreased value = failure to pay

By the end of the mortgage duration, you have to repay the loan balance all at once. If you rely on your investment accounts and the property value to increase so you can sell and pay off in the end,  there’ll be a risk that follows. If the property value decrease due to maintenance, structure or location related issues, you will not be able to sell easily with the same price you bought..

  • High interest paid

If you did not make extra payment for your loan balance during the mortgage duration, you’ll end up paying more interest comparing to Normal Mortgage. Your interest is based on your existing loan balance, therefore it will continue to remain high.

Conclusion

Interest Only Mortgage is a double edged sword. While paying just low interest payment monthly seems to be very attractive, and yet the cost of your loan balance will remain high.  If you choose to go for this type of mortgage, it is important to be diligent by putting the extra money you saved monthly into repaying your loan balance gradually without procrastinating this important payment till the end.

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